EM corporate bonds, an income opportunity
The market action of recent weeks was driven by a drive to cash affecting asset classes across the board. The coronavirus situation is the main cause, exacerbated by the oil-price shock in early March.
Bond investors are now evaluating the potential economic impact on economic growth from a lockdown in multiple economies, with some concerned about the repayment ability of multiple emerging (and developed market) issuers. Consequently, the asset class has seen outflows, driving prices down to levels that, in our view, are not justified by underlying fundamentals.
In the hunt for cash, both short- and long-term bonds corrected severely with usually liquid bonds also seeing liquidity disappear quickly. We see this phenomenon as flow driven, primarily by forced sellers, possibly ETFs, as they have to buy or sell based on the orders they receive.
As cash generation became primary, short-term bonds often exhibited similar price corrections as long-term bonds, sometimes pushing steep curves into inverted curves. In our view, for many names, there is now a dislocation between the short and the long end. Therefore, we see value at the shorter end. However, bid-offer spreads are wide, making the trading environment challenging and causing big price swings on small volumes.
Understandably, in this sort of environment, investment-grade bonds have outperformed high yield, and oil importers have done better than oil exporters.
In the EM space, Africa has corrected the most, this is due to the oil-price shock and fears concerning the possible impact of coronavirus on the continent.
The demand for liquidity caused by the sudden dash for cash is being matched by global developed market central banks, but will take time to trickle through to EM. More immediate relief for EM is on the way though, with the World Bank and IMF pushing for more action and temporary debt relief. Although, for EM markets to benefit, it will require concrete actions rather than proclamations.
The severe disruption that we are seeing will inevitably result in some restructurings. However, we see it as largely reflected in prices. The key is to stay diversified. We believe volatility will remain, but as the selloff has been so broad, we are seeing opportunities across different sectors and geographies appear.
Due to the severity of the market correction, we expect a rebound that will likely begin with the more liquid, higher-quality names. So, as investors begin to move back into the market, they will likely be looking at sovereigns, quasi-sovereigns, and larger corporates. Then, when confidence returns, we expect the high-yield and riskier names to react and follow.
With the most significant selloff since 2008, the vast majority of carry is now coming from the spread. We believe that in many cases pricing has disconnected from fundamentals (particularly for the smaller issues) resulting in mispricings. As active and contrarian investors, we are not looking to buy the market, we are looking to buy the mispricings in the market. When the market calms and investors begin to see the value in EM bonds, we believe, that by taking advantage of the mispricings, investors can again benefit over the long term.